India's Love For Gold Can't Be Curbed With Tariff Hikes

In a hope to curb imports and control its current account deficit, the Government of India raised the import duty by 2% to 6%. However, officials expect that there will be only a minimal drop in the demand of gold. So, really this is simply another means by which to close the budget deficit because of the domestic inelasticity of demand for gold. The Indian government wants to reduce gold's share of its import bill from 11.5%, the second-highest item after oil.

The main reason for the duty hike is the rising current account deficit, driven largely by India's traditionally large gold imports - demand which has grown with the price pulling back below $1600 per ounce and the rupee strengthening somewhat from its worst levels. The current account deficit reached an all time high of 5.4% of Gross Domestic Product in the third quarter of 2012. India's current account deficit problems look similar to the balance of payments crisis in 1991, when the Reserve Bank of India had to sell 47 tons of gold to Europe as collateral for a loan to avert a sovereign default.

Indians see Gold as an investment asset, but it represents a drain on foreign currency reserves. The inflation rate is 7% and RBI has kept all the key lending rates at 8%, so the 13% rise in domestic gold prices in 2012 will definitely look attractive to many investors. On India's Multi Commodity Exchange, the most active gold contract increased by more than 10 percent in spot gold than in the previous year and surged up to 13 percent making record highs above 32,000 rupees (NYSEARCA:ICN) per 10 grams.

India is the world's biggest gold consumer, a title that now passes back and forth with China. The jewelry industry in the country is estimated to be worth $200 billion a year, with a majority of demand being met by imports. India's lust for gold is a major factor determining the global prices.

The rising price and import tariffs did have an effect, however, on imports for ornamental purposes. According to India's Jewelry Association, imports from that sector could drop 15% after this move to a 6% tariff. The Bombay Bullion Association estimated that India's gold imports fell by 43-45% in 2012 to around 532 tones after the import duty was doubled. According to WGC, the demand for gold in India for 2012 was down 12%, but the final quarter registered an increase of 41% year-over-year due to the mix of a stronger rupee, lower international price and the threat of a duty hike that has now materialized.

However, large Indian gold brands and the general populace believe otherwise. Gitanjali Group - a $2.5 billion U.S. multinational -- said that they anticipate nearly no effect on sales by a duty hike of 1-2%. India's established traditions will keep demand for gold high. Purchasing gold is a need in India not a luxury. Despite duty hikes there are still cultural imperatives at work and a general mistrust of government issued money. Similar to what was seen in the U.S. in early January, the possible increase in the gold prices and the new tax year sent buyers into a frenzy. When the dust settles, traders believe that as much as 40-50 tons of gold could have been imported in the first week of January alone - a month's worth in just a few days.

The Government and Reserve Bank of India have exerted a lot of effort to encourage investors to consider instruments such as gold bonds, deposit schemes and gold based funds. The effort has, however, seen little success. Indians know the value of physical gold over a paper claim for it. In rural areas of India, where 69% of the population dwells, there is not a reliable banking infrastructure, so paper gold is simply not an option.

The best course of action for the Indian government is to fix the other aspects of its budget and current account problems. If anything, the RBI needs to maintain rates and create more of an international market for the rupee rather than demonizing gold imports. Between the mess that has been made of oil imports, which make up a lot more of the current account problems, and the need to attract more foreign investment, the Indian government has to shore up its credibility gap with its citizenry before it can entice a large enough segment of the population to mobilize any of its saved gold, estimated at between 20,000 and 25,000 tons. With elections looming in 2014 it doesn't have a lot of time. Reforming the diesel and cooking gas subsidies were a good start but will be implemented too slowly to improve the situation in the short term.

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